Ineligibility criteria u/s 29A of IBC: A net too wide!

-By Richa Saraf & Sikha Bansal (resolution@vinodkothari.com)

 

Resolution plan is designated to be the “way-out” for insolvent entities coming under the Insolvency and Bankruptcy Code, 2016. The resolution professional appointed by the adjudicating authority constitutes a committee of creditors, invites resolution plans from prospective resolution applicants, and places the resolution plans before the committee of creditors. The resolution plan which is approved by the committee of creditors is submitted to the adjudicating authority for sanction. A resolution applicant, as defined under section 5(25) of the Code, earlier referred to mean any person who submits a resolution plan to the resolution professional. Hence, a resolution applicant might have been any person- a creditor, a promoter, a prospective investor, an employee, or any other person. The Code had not gone into the basis and criteria for selection of the resolution applicant. This became a fatal loophole in the law which allowed back-door entry to defaulting promoters at substantially discounted rates for the assets of the corporate debtor.

To curb the illicit ways, several amendments were made in the Code, first by way of Insolvency and Bankruptcy Code (Amendment) Ordinance, 2017[1] dated 23rd November, 2017, then by Insolvency and Bankruptcy Code (Amendment) Act, 2018[2] dated 19th January, 2018 (“Amendment Act”). Of all the amendments, the one which has become a riddle for all is section 29A. The section specifies persons not eligible to be resolution applicant, and has ten parts (i.e. clauses), the tenth part is further divided into three sub-parts, of which the third part has its own descendants. These layers of section 29A are more in the nature of elimination rounds. The write-up below digs deeper into the section.

Resolution Applicant – Who and Who Not?

Vide the Amendment Act, the definition of “resolution applicant” was amended so as to mean a person, who individually or jointly, submits a resolution plan to the resolution professional pursuant to the invitation made under section 25(2)(h).

Section 25(2)(h) requires the resolution professional to invite resolution plans from prospective resolution applicants who fulfill criteria as laid down by the resolution professional with the approval of committee of creditors, having regard to the complexity and scale of operations of the business of the corporate debtor and such other conditions as may be specified by the Board.

Section 29A is a restrictive provision- any person falling in the negative list is not eligible to submit a resolution plan.

Therefore, a person in order to be eligible to submit a resolution plan –

  • shall fulfill the criteria laid down by the resolution professional with the approval of the committee of creditors; and
  • shall not suffer from any disqualification mentioned under section 29A.

Section 29A – A Pandora Box

According to Section 29A, a person suffering from the disqualifications as mentioned hereunder shall not be eligible to submit a resolution plan. Further, any other person acting jointly or in concert with the prospective resolution applicant shall not be covered under the following disqualifications –

  • (i) the person is an undischarged insolvent;
  • (ii) the person is a wilful defaulter in terms of the RBI Guidelines issued under the Banking Regulation Act, 1949;
  • (iii) the person has an account, or an account of a corporate debtor under the management or control of such person or of whom such person is a promoter, classified as non-performing asset in accordance with RBI Guidelines issued under the Banking Regulation Act, 1949 and at least a period of 1 (One) year has lapsed from the date of such classification till the date of commencement of the corporate insolvency resolution process of the corporate debtor: Provided that the person shall be eligible to submit a resolution plan if such person makes payment of all overdue amounts with interest thereon and charges relating to non-performing asset accounts before submission of resolution plan;
  • (iv) the person has been convicted for any offence punishable with imprisonment for 2 (Two) years or more;
  • (v) the person is disqualified to act as a director under the Companies Act, 2013;
  • (vi) the person is prohibited by SEBI from trading in securities or accessing the securities markets;
  • (vii) the person has been a promoter or in the management or control of a corporate debtor in which a preferential transaction, undervalued transaction, extortionate credit transaction or fraudulent transaction has taken place and an order has been made by the adjudicating authority under the provisions of the Code;
  • (viii) a person who has executed an enforceable guarantee in favour of a creditor, in respect of a corporate debtor against which an application for insolvency resolution made by such creditor has been admitted under the Code;
  • (ix) a person who has been subject to the above listed disabilities under any law in a jurisdiction outside India;
  • (x) connected persons, i.e. persons connected to the person disqualified under any of the aforementioned points, such as those who are promoters or in management of control of the resolution applicant, or will be promoters or in management of control of the business of the corporate debtor during the implementation of the resolution plan, the holding company, subsidiary company, associate company or related party of the above referred persons – exception has been carved out for scheduled banks, asset reconstruction companies registered with RBI under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, and alternative investment funds registered with SEBI.

Major aspects of the provision have been analysed as below-

Layers of Ineligibility

An assiduous analysis of Section 29A reveals that the section imposes four layers of ineligibility, as mentioned below-

  • First layer ineligibility, where the person itself is ineligible;
  • Second layer ineligibility, i.e. where a “connected person” is ineligible;
  • Third layer ineligibility, i.e. being a “related party” of connected persons; and
  • Fourth layer ineligibility, where a person acting jointly/in concert with a person suffering from first layer/second layer/third layer ineligibility, becomes ineligible.

 

 

Clause (c): The NPA Criterion

Clause (c) of Section 29A debars a person or a person acting jointly or in concert with such person who-

  • has an account classified as NPA;
  • is a promoter of a corporate debtor the account of which has been classified as NPA;
  • is in the management of a corporate debtor the account of which has been classified as NPA;
  • is in control of a corporate debtor the account of which has been classified as NPA.

At least a period of 1 (One) year should have elapsed from the date of classification till the insolvency commencement date. Therefore, any company (including the promoters/persons in the management of or control of such company) which has its account classified as NPA for last 1 (One) year will not be able to file a resolution plan however, the Code provides for a carve out that such person shall be eligible to submit the resolution plan if such person makes payment of all overdue amounts with interest thereon and charges relating to non-performing asset accounts before submission of resolution plan. See also, clause (j) of Section 29A.

Clause (g): Vulnerable Transactions

According to clause (g) of Section 29A, a promoter/person in the management of or control of a corporate debtor in which a preferential transaction (Section 43), undervalued transaction (Section 45), extortionate credit transaction (Section 50), or fraudulent transaction (Section 49) have taken place and the adjudicating authority has passed an order under the Code. The provision is qualified to the extent it uses the term “corporate debtor”, and that the adjudicating authority should have passed an order under the Code itself.

Clause (h): Guarantor executing guarantee in favour of the applicant creditor

The negative list includes persons who might have guaranteed the obligations of the corporate debtor which is currently in insolvency. As the provision goes, a person who has executed enforceable guarantee in favour of a creditor in respect of a corporate debtor against which an application for insolvency resolution made by such creditor has been admitted under the Code. Going by the construction of the clause, it appears that the guarantee should be in favour of that creditor who has applied for insolvency resolution of the corporate debtor.

The provision came up for discussion in RBL Bank Ltd. v. MBL Infrastructures Ltd. [CA(IB) No. 543/KB/2017; order dated 18.12.2017], where NCLT took a view that there was no intent of the Government to debar all the promoters, only for the reason for issuing a guarantee which is enforceable, unless such guarantee has been invoked and not paid for, or the guarantor suffers from any other antecedent listed in section 29A. The resolution applicants stated that by purporting to disqualify the entire class of guarantors under the said clause would be violative of the valuable rights of the applicant. If the guarantee is not invoked and demand is not made on the guarantor, the debt payable by him is not crystallized and the guarantor cannot be therefore said to be in default for breach of the guarantee and be penalized merely because a legal and binding contract of guarantee exists, which is otherwise impossible but is subject to its invocation in accordance with the terms of the guarantee. The NCLT agreed to the view observing that the guarantors in respect of whom, a creditor has not invoked the guarantee or made a demand under guarantee should not be prohibited. Therefore, no default in the payment of dues by the guarantor has occurred, cannot be covered under clause (h) of Section 29(A). It cannot be the intent of clause (h) to penalize those guarantors who have not been offered an opportunity to pay by calling upon them to pay the dues, by invoking the guarantee. Therefore, the words “enforceable guarantee” appearing in clause (h) are not to be understood by their ordinary meaning or in the context of enforceability of the guarantee as a legal and binding contract, but in the context of the objectives of the Code and Ordinance in general and clause (h) in particular.

Clause (j): Connected persons

The word “connected persons” appear in clause (j) of section 29A. A person who is connected to the persons as defined under the Explanation, shall be disqualified if the other person suffers disability under clause (a) to (i) of section 29A.

“Connected persons” have been defined so as to include three categories –

Explanation.— For the purposes of this clause, the expression “connected person” means-

(i) any person who is the promoter or in the management or control of the resolution applicant; or

(ii) any person who shall be the promoter or in management or control of the business of the corporate debtor during the implementation of the resolution plan; or

(iii) the holding company, subsidiary company, associate company or related party of a person referred to in clauses (i) and (ii):

The definition can be analysed as follows-

  1. Clause (i) includes:
    1. promoter;
    2. person in the management; and
    3. person in control

of an ineligible resolution applicant.

Further, in accordance with clause (iii),

  • where (a) or (b) or (c) is a company, the holding, the subsidiary, and the associate companies or “related party” of (a), (b), (c) (as the case may be), shall also be disqualified.
  • where (a) or (b) or (c) is a natural person, any “related party” of such person shall also be disqualified.

 

  1. Clause (ii) basically seeks to debar persons from submitting resolution plans in which persons suffering from disabilities mentioned under Section 29A are proposed as promoters or in the management of or in the control of the corporate debtor during implementation of the resolution plan. It includes-
    1. would-be promoter;
    2. person, would-be in the management; and
    3. person, would-be in control

of the corporate debtor, who suffer from disqualification under section 29A.

For example, A wants to submit resolution plan for B Ltd. A proposes that C shall be in the management of B Ltd. during the implementation of the resolution plan. However, C is a person suffering disability under Section 29A. A, therefore becomes ineligible to submit resolution plan.

Further, in accordance with clause (iii),

  • where (a) or (b) or (c) is a company, the holding, the subsidiary, and the associate companies or “related party” of (a), (b), (c) (as the case may be), shall also be disqualified.
  • where (a) or (b) or (c) is a natural person, any “related party” of such person shall also be disqualified.

For scope of the term “related party”, see below.

Note that from the scope of “holding company, subsidiary company, and associate company”, the following have been excluded, i.e. the following can proceed to submit the resolution plan-

  • a scheduled bank; or
  • an ARC registered with RBI under section 3 of the SARFAESI Act, 2002; or
  • an AIF registered with SEBI.

Related party

“Related party” has been defined in Section 5 (24); however, the definition is specific to corporate debtor, i.e. the definition specifies the persons who shall be treated as “related party’ of the corporate debtor. Hence, where the persons referred to in clauses (i) and (ii) of the Explanation are persons other than the corporate debtor, the definition under section 5(24) becomes irrelevant, and the following may be noted-

  • Where one of the person is a company, “related party” shall be interpreted in terms of section 2(76) of the Companies Act, 2013;
  • Where none of the persons is a company, the definition of the term “related party” has been left open. In the context of natural persons, generally the term “relative” is used.

Associate Company

For the purpose of determining whether a company is an associate of the other, the definition as under Section 2(6) of the Companies Act, 2013 shall be referred, wherein “Associate company”, in relation to another company, means a company in which that other company has a significant influence, but which is not a subsidiary company of the company having such influence and includes a joint venture company.

For the purpose of the said definition, “significant influence” means control of at least 20% (twenty per cent) of total share capital, or of business decisions under an agreement.

For example- “Company X” holds 20% of total share capital of Company “Y”, then Company X will be deemed to be an associate company of Company Y.

Relevant time- whether lookback allowed?

A relevant question would be regarding the point of time at which the ineligibility has to be ascertained. The language of the section suggests that only present status of the resolution applicant has to be seen. No lookback period has been prescribed. However, the authors opine that it would be upon the committee of creditors to decide on whether any past event shall be weighed upon while making the final decision.

More of a Diktat?

The Code has been designed to find the best possible way out for an ailing entity- it was meant to be more inclusive in approach. However, the reach of Section 29A extends to four layers (as explained above), and may lead to exactly opposite results. The intent of the Code was not to restrict genuine applicants, but only to exclude participation from habitual miscreants or applicants who might themselves be sick, however, Section 29A may result in elimination of persons who might be interested in buying stakes in the entity.

See RBL Bank Ltd. v. MBL Infrastructures Ltd. [CA(IB) No. 543/KB/2017; order dated 18.12.2017], where the NCLT, considering the objective of the Ordinance, 2017, opined that clause (h) of section 29A is not to disqualify the promoters as a class for submitting a resolution plan. The intent is to exclude such class of persons from offering a resolution plan, who on account of their antecedents, may adversely impact the credibility of the processes under the Code. The case is, for the time being, pending with NCLAT[3].

The Code was designed to find the best possible way out for an ailing entity- it was meant to be more inclusive in approach and there was definitely no intention to avoid promoters from submitting resolution plans. However, the reach of Section 29A extends to four layers (as explained above), and may lead to exactly opposite results. It is quintessential to ensure that the citadel of insolvency resolution does not have holes into it but at the same time, it is also important to ensure that the citadel is not inaccessible, with no steps, doors or windows.

The intent of Section 29A will be counter- productive if it results into a whole lot of intending resolution applicants being disentitled, because the recursive definitions of related party, connected persons etc are cast wide enough, intertwining all the entities promoted by an entity.


[1] http://ibbi.gov.in/webadmin/pdf/legalframwork/2017/Nov/180404_2017-11-24%2007:16:09.pdf

[2] http://ibbi.gov.in/webadmin/pdf/legalframwork/2018/Jan/182066_2018-01-20%2023:35:29.pdf

[3] Last update as on 10.02.2018.

An Insight on Direct Selling Guidelines, 2016 Pyramid Schemes vis-a-vis MLM

By Saloni Mathur (finserv@vinodkothari.com)

Introduction

There has been a shift in the paradigm of the performance of the direct selling agents. The role and responsibilities of the direct selling agents have witnessed a revolution, where they are required to comply with certain codes as prescribed by the government from time to time, and follow certain practises while discharging their responsibilities. The RBI’s master directions[1]on the outsourcing norms have put stringent compliances on the service providers while discharging their functions, and increased responsibility and monitoring on the part of the non-banking financial companies. The question that arises here is whether those non- banking companies complying with the outsourcing guidelines, fall under the ambit of the direct selling guidelines also and if they, then what is the nature of the applicability of these direct selling guidelines on them.

According to a report on the Indian direct selling industry published by FICCI and KPMG, the direct selling market in India has grown at a CAGR of 16 per cent over the past five years to reach INR75 billion today.[2] Due to this unprecedented rise in direct selling industry and the growth of a large distribution base, major scams have been witnessed over the years in reputed companies owing to the nature of marketing methods adopted by them.

The Government of India, Ministry of consumer affairs, food and public distribution, department of consumer affairs, vide its notification number F.No.21/18/2014-IT (vol II) dated 09th September, 2016 modelled certain guidelines on the direct selling regulating the business of direct selling and the multi-level marketing.

This article is an attempt to envisage the rationale behind these guidelines and the applicability of these guidelines on the direct selling agents and the various compliances that are required to be made by the direct selling entities and the direct sellers.[3] Further this article also takes into account the concept of Multi-level marketing and the pyramid schemes with reference to the applicability on the direct selling agents.

Rationale behind the launch of the Scheme

The direct selling industry has brought about with itself a huge reservoir of marketing, selling and distribution base for the goods and services, which has given rise to various fraudulent practises in the marketing and the distribution system. Instances can be drawn from the famous Amway and the Qnet case where entire money in the chain was earned only through the recruitment of new members and adding more participants to the channels of distribution, rather than the actual sale of the goods and services. Though the Amway was convicted of “illegal pyramid scheme” it could finally escape all criticism under the umbrella of the “the Amway safeguard rules”. However, the case has left strong marks of scepticism in the validity of the direct selling business.

The companies which were engaged in multi-level marketing were carrying out various frauds through the recruitment of large number of participants in the system. Thus, a need was felt where a robust system of direct selling guidelines was required to protect the interest of the consumers.

Defining the Pyramid and the MLM schemes

Defining the Pyramid Scheme

“Pyramid Scheme” as defined in the guidelines mean a multi layered network of subscribers to a scheme formed by subscribers enrolling one or more subscribers in order to receive any benefit, directly or indirectly, as a result of enrolment, action or performance of additional subscribers to the scheme. The subscribers enrolling further subscriber(s) occupy higher position and the enrolled subscriber(s) lower position, thus, with successive enrolments, they form multi-layered network of subscribers.

The key feature of the pyramid is that as the entrants in the last layer of the pyramid continue to get more and more participants who pay money. By way of this a hierarchy is created and the sponsor who holds the top most position is the recipient of the highest commission. The Amway case is the perfect example of the “illegal Pyramid scheme” where the purpose of the scheme was to make money through recruiting more distributors at various levels.

The pyramid scheme is illegal in India under the Prize chits and Money Circulation Schemes (banning) act, 1978. Hence there is a non-applicability of this scheme.

Following are some of the key constituents of the Pyramid Schemes

High registration fees

The basic quality of a pyramid scheme is that there is a high registration and entry fees upfront that the participants in the scheme have to pay. The entry fee is so high that the participants holding top position get a very high commission fees.

Goods sold at a price higher than the fair value and a higher quantity that is generally sold in the market

The goods and services under the pyramid schemes are not sold at the fair value. Fair value means the price at which the goods and services are generally available in the market. If the goods are sold to the consumers at a price higher than what is a general fair market price, it is a pyramid scheme.  Similarly, if the goods are sold at a quantity higher than what is expected to be consumed by, or sold, resold to consumers, it will constitute to be a pyramid scheme. The price of the goods and services have a higher component of commission cost rather than the actual product price. The price of the product generally has 70% commission cost and remaining 30% cost of the product.

The level of unsold inventory

Under the pyramid schemes the unsold inventories of the participants is not generally brought back by the distributor.

Emphasis on the recruitment of more members

There is a greater emphasis on the recruitment of more members rather than promoting and distributing the product. The purpose here is to fetch higher commissions for the sponsors at the top most level.

No material contract between the direct selling entity and the direct seller

There is no material agreement entered between the direct selling entity and the direct seller on buy back, refund, repurchase policy of the unsold inventory.

No cooling off period

There is no cooling off period given to the direct sellers up to which they can cancel the contract.

Defining the Multi-level Marketing (MLM) scheme

In an MLM structure, multi-level marketing or the network marketing are used to sell the products directly to the consumers in which the salesmen are compensated not only for the work done by them but also for the sales of the people who have joined the company through them.[4]

The main purpose of the MLM scheme is to ensure wide distribution of the products or services and the intent is to sell the product through a network of wide range of distributors. Thus, it is just a marketing strategy unlike a fraudulent pyramid scheme where there are tangible distribution of the goods and services.

Comparing the MLM and the ‘Pyramid’

The big difference between multilevel marketing and a pyramid scheme is in the way the business operates. The entire purpose of a pyramid scheme is to get distributors’ money and then use it to recruit other distributors. The entire purpose of MLM is to move the product and ultimately achieve the sales of the product. The theory behind MLM is that the larger the network of distributors in a chain, the more products the business will be able to sell. Therefore, whether it is a pyramid scheme or an MLM approach depends upon the legality of the schemes and the purpose behind their operation as the Pyramid scheme is illegal.

Defining key concepts under the ‘direct selling guidelines 2016’

‘Direct selling’ has been clearly defined in regulation 6 which means marketing, distribution and the sale of the goods or providing of any services as a part of network of direct selling other than under a pyramid scheme.

Thus, what constitutes to be a direct selling is based on four conditions i.e direct selling has to be marketing, distribution, and selling of the goods and services as a part of network of direct selling. Thus all the four conditions need to be qualified simultaneously for determining direct selling. Thus, a direct selling agent, if restricts its services only to marketing of products and not to selling and distribution would not be required to comply with these guidelines.

Similarly, the network is defined as an arrangement of intersecting horizontal and vertical lines. To be a network it is therefore necessary that there is a hierarchy of a direct selling agents such that there is a superior subordinate relationship at all levels of distribution

The ‘network of direct selling’ means a network of direct sellers at different levels of distribution who may recruit or sponsor further levels of the direct sellers, who they then support. “Network of direct selling” shall mean any system of distribution or marketing adopted by a direct selling entity to undertake direct selling business and shall include the multi-level marketing method of distribution.

This network of direct sellers also includes the multi-level marketing method of distribution.

Thus, network of direct selling shall be hierarchical. Single level of distribution would not constitute any network.

Comparing the network, the Pyramid and the MLM

The network may be at a horizontal level also. For example, if there is one direct selling entity selling goods and services through a single level of the direct sellers, all at the same level shall constitute a network. However, Pyramid necessarily has to be a vertical hierarchy such that there should a superior subordinate relationship. Multi-level marketing shall have to a be a legal marketing strategy and not a fraudulent scheme.

Understanding the applicability of the scheme

The applicability of the above guidelines on the direct and selling agents have to be checked from the following facts:

This scheme is applicable on the following companies.

  1. Companies engaged in marketing as well as selling and distributing the products simultaneously under the network of direct selling.
  2. All the multi-level marketing schemes such that there are different levels of distribution and the participants are at different distribution levels. Here the participants at the same level of distribution shall not be required to comply with the scheme.
  3. Company carrying its operations through a hierarchical multi-level system.
  4. Companies appointing the direct selling agents in such a way, such that they are sponsoring or carrying out recruitment further so that a large network of distribution is created
  5. Companies that have relevant clauses in the outsourcing agreement and which specifically reflect the outsourcing or subcontracting of the service to the third parties.
  6. Companies requiring direct selling agents to pay high membership fees and greater entry costs.

Non-Applicability of the guidelines to Pyramid schemes and companies having only one level of distribution

The guidelines shall not be applicable to the pyramid scheme. This is because these schemes are generally money-making schemes and not any legal marketing strategy. This comes from the fact that pyramid schemes are generally created not to market the products, but to create a distributor base for earning large money through promotion. Thus, the direct selling guidelines take a legal view and apply to only legal MLM schemes and direct selling.

Further the companies having only a horizontal distribution base such that they are not recruiting or sponsoring further levels in the chain shall be kept out of the purview of these guidelines.

Quick compliance checklist for direct selling guidelines 2016

  1. All direct selling companies in India shall submit an undertaking to the department of the consumer affairs within 90 days from 12th September 2016.
  2. Direct seller cannot receive remuneration or incentive for the recruitment/enrolment of the new participants.
  3. Direct sellers can only receive remuneration derived from the sale of goods or services
  4. Direct seller shall carry its identity card and not visit the customers premises without prior intimation/approval.
  5. Direct selling company cannot force its direct sellers to purchase more goods or service than they can expect to consume or sell.
  6. Direct selling company cannot demand any entry fee/registration fee.
  7. Company must provide every participant written contracts describing the material terms (buy back, re-purchase policy, cooling period, warranty and refund policy.
  8. Mandatory orientation session with accurate information for the newly recruited direct selling agents
  9. There shall be prohibition of the pyramid scheme and the money circulation scheme.
  10. There shall be a monitoring authority to deal with the issues related to the direct selling.

Conclusion

There is no scepticism regarding the benefits of the direct selling guidelines on the interest of the consumers in prevention of the frauds against them, however comprehending the applicability of these directions is a hard nut to crack for various entities who are in a dilemma to comply with these guidelines. The guidelines do not specifically state the extent of the applicability; however, they do give certain apparent indications to the entities to whom these guidelines shall be applicable.

Thus, any company desirous of increasing their distribution base for selling wide range of products or services and who intend to do it by creating a hierarchical distribution that requires further outsourcing and recruitment shall be required to comply with the guidelines. Further the outsourcing agreement between the DSA and the service provider shall clearly state the provisions regarding contracting and the sub-contracting, subsequent to which only a network of distributors could be created.


[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT87_091117658624E4F2D041A699F73068D55BF6C5.PDF

[2] https://www.souravghosh.com/blog/direct-selling-guidelines-2016/

[3] http://consumeraffairs.nic.in/writereaddata/Direct%20Selling%20guidelines.pdf

[4] https://www.icsi.edu/WebModules/LinksOfWeeks/JuneCS_2014.pdf

Consultative meeting with stakeholders (Minutes of the meetings have been shared with the respective stakeholders)

FAQs on Layers of Subsidiaries

By Team Vinod Kothari & Company | December 21, 2017 (corplaw@vinodkothari.com)

 

MCA vide its Notification[1] dated September 20, 2017 notified the Companies (Restriction on Number of Layers) Rules, 2017, imposing a limit of two layers of subsidiaries which is effective from September 20, 2017[2]. In this regard, the following FAQs discusses various questions relating to the provisions dealing with layers of subsidiaries:

  1. Which all sections deal with restriction on layers of subsidiaries in Companies Act, 2013 (‘CA, 2013’)?

The following are the two sections which deals with restriction on layers of companies:

  • Proviso to Section 2 (87) [definition of subsidiary company or subsidiary]: As per the proviso, such class or classes of holding companies (as may be prescribed) shall not have layers of subsidiaries beyond such numbers as may be prescribed.
  • Section 186 (1) [Loan and investment by company]: As per this Section, a company shall unless otherwise prescribed, make investment through not more than two layers of investment companies.
  1. What is meant by ‘layer’ under Section 2 (87) of the CA, 2013?

The word “layer”, referred to in Section 2(87), means subsidiary or subsidiaries of the holding company.  The same word has also been used in Section 186 (1). Given the intent of the section, ‘layer’ refers to vertical limit.

  1. What is the reason behind limiting the number of layers?

The Joint Committee on Stock Market Scam[3] provided that on account of layers it became difficult to link the source of fund with the actual users to which these fund were put.

The multiple layers of companies are used by the companies for syphoning of funds and for money laundering. Therefore, in order to curb such practices by the companies, the government has provided restriction on floating layers of companies.

  1. Is there any restriction on horizontal propagation?

The restriction in layers of subsidiaries is for vertical propagations and not for horizontal propagations. A company may have as many investments horizontally. The same can be illustrated with the following diagram:

 

Figure 1: Horizontal propagation of Company A

  1. Are there any exceptions to proviso of section 2 (87)?

In addition to the exceptions given in section 186 (1), the Companies (Restriction on number of layers) Rules, 2017 (‘Rules, 2017’) also provides exception to the following companies:

  • a banking company;
  • a non-banking financial company as defined in the Reserve Bank of India Act, 1934 (2 of 1934) which is registered with the Reserve Bank of India and considered as systemically important non-banking financial company by the Reserve Bank of India; (Nothing specified in relation to housing finance companies/ NBFC CICs).
  • an insurance company being a company which carries on the business of insurance in accordance with provisions of Insurance Act, 1938 and Insurance Regulatory Development Authority Act, 1999;
  • a Government company referred to in clause (45) of section 2 of the Act.
  1. Are the provisions applicable on subsidiaries incorporated outside India?

First proviso to Rule 2 of the Rules provides exemption to a Company from acquiring a company incorporated in a country outside India with subsidiaries beyond two layers as per the laws of such country.

The exemption in case of acquiring of subsidiaries incorporated outside India should have been extended equally to subsidiaries freshly incorporated outside India. There shouldn’t have been a distinction in acquisition and incorporation of subsidiary outside India. Either a company may acquire a subsidiary outside India which in turn has several layers of downstream investment or it may float a subsidiary outside India which will keep on further incorporating or acquiring subsidiaries outside India.

It will be incorrect to say that Company incorporating subsidiaries outside India will have to adhere to the restriction of layers even if the same is permitted as per law of that country.

  1. Are the wholly owned subsidiaries even counted in the limits of layer?

The second proviso to Rule 2 of the Rules provides:

“Provided further that for computing the number of layers under this rule, one layer which consists of one or more wholly owned subsidiary or subsidiaries shall not be taken into account.”

As per the above-mentioned provision, a layer which consists of one or more wholly owned subsidiary or subsidiaries shall not be taken into account while computing the number of layers i.e., one layer which is represented by a wholly owned subsidiary shall not be taken into account.

‘Layer’ cannot mean ‘Layers’ based on interpretation that singular includes plural. Therefore, it should not be read as any layer represented by a wholly owned subsidiary. The whole purpose will get defeated if companies are allowed to incorporate layers of wholly owned subsidiaries without any restriction. Therefore, the exemption is only in a layer which represents a wholly owned subsidiary. However, it is pertinent to note that the layer of wholly owned subsidiary has to reflect in the first layer and not thereafter in order to avail the exemption.

The permitted layers can be illustrated with the following diagram:

Figure 2: Permitted layers of subsidiaries

  1. Whether the Rules are prospective or retrospective?

As per Rule, after the date of commencement of the Rules, the holding companies, other than the exempted companies, which has number of layers of subsidiaries in excess of the limit of layers:

  • shall not have any additional layer of subsidiaries over and above the layers existing on such date; and
  • shall not, in case one or more layers are reduced by it subsequent to the commencement of these Rules, have the number of layers beyond the number of layers it has after such reduction or maximum layers allowed in sub-rule (1), whichever is more.

Therefore, companies will have to comply with these conditions prospectively.

  1. Whether acquisition, as mentioned in the Rules, covers intra group transactions?

Yes, acquisition here refers to any acquisition which has the result of making the entity being acquired, the subsidiary of the acquiring entity. Accordingly, intra group transactions as well as external transactions shall be covered.

  1. Whether it is possible to acquire a company incorporated outside India which has no subsidiary? Or has subsidiaries within two layers even if the laws of the host country permit beyond 2 layers?
Draft Rules[4] Final[5]
After the date of commencement of this rule, every holding company, other than a holding company belonging to a class specified in sub-rule

(2), shall have not more than two layers of subsidiaries:

On and from the date of commencement of these rules, no company, other than a company belonging to a class specified in sub-rule (2), shall have more than two layers of subsidiaries:
Provided that the provisions of this sub-rule shall not affect a holding company from acquiring a subsidiary incorporated in a country outside India if such subsidiary has subsidiaries as per the laws of such country. Provided that the provisions of this sub-rule shall not affect a company from acquiring a company incorporated outside India with subsidiaries beyond two layers as per the laws of such country:

By virtue of Rule 2(1) a company cannot have more than two layers of subsidiaries unless the company is covered in exemption list provided in Rule 2 (2).

The carve-out given in the proviso under draft rules explains that the overseas subsidiary being acquired may have any number of subsidiaries permitted as per law of host country. The final rules amended the wording to clarify that even if such subsidiaries have more than two layers of subsidiaries as per laws of such country, the holding company can acquire such subsidiary. The intent is to make it abundantly clear that if the acquiring entity is likely to breach the limit of layer of subsidiary on account of acquisition of company incorporated outside India, the rule shall not apply. There is no precondition that the company being acquired abroad should have two layers of subsidiaries.

  1. Is there any filing requirement for companies which has number of layers of subsidiaries in excess of the limit?

Every company, other than the companies exempted under the section, existing on or before the commencement of these rules, which has number of layers of subsidiaries in excess of the layers specified, shall file return in Form CRL-1 with the Registrar within a period of 150 days from the date of publication of these Rules in Official Gazette i.e., September 20, 2017. The form requires specifying layer number of the subsidiary and percentage of shares held by holding company. The format as prescribed in the Rules requires certifying the form, therefore, the e-form is much awaited. However, in the absence of the e-form, CRL-1 should be filed in e-form GNL-2 before the expiry of 150 days from the date of publication of these Rules.

  1. Is there any penal provision for contravention of these Rules?

If any company contravenes any provision of these Rules then the company and every officer of the company who is in default shall be punishable with fine which may extend to ten thousand rupees and where the contravention is a continuing one, with a further fine which may extend to one thousand rupees for every day after the first during which such contravention continues.

  1. What is meant by ‘layers of investment companies’ under Section 186 (1) of the CA, 2013?

Section 186 (1) of the CA, 2013 puts down restriction on companies to make investments through more than two layers of investment companies. In this case, it refers to vertical layers of investments companies.

The expression ‘investment company’ means a company whose principal business is the acquisition of shares, debentures or other securities.

There is no exemption to any company from adhering to the requirement of Section 186 (1).

  1. Are there any exceptions to the provisions of section 186(1)?

Yes. The proviso exempts the applicability of this section to:

  • Acquiring of any company incorporated outside India if that company has investment subsidiaries beyond two layers as per the laws of that country.
  • Subsidiary company from having an investment subsidiary to fulfill any regulatory requirement.
  1. Section 2(87) postulates that a relationship of subsidiary can be established if one controls the Board of the other company. Whether such category of subsidiary falls within the purview of Section 186(1)?

Section 186(1) of CA, 2013 nowhere talks about investment through subsidiary. Hence for the purpose of section 186(1) control over the board of company will not be reason enough for attracting the provision of section 186(1).

If such subsidiaries are investment companies, section 186(1) shall be attracted.

  1. What is the difference between the provisions of proviso to Section 2 (87) and 186(1)?

A tabular presentation of the difference between the proviso to section 2(87) and section 186(1) of the CA, 2013 is presented below:

Criteria Proviso to Section 2(87) Section 186(1)
Applicability On all companies [Except few exceptions mentioned in above question] On all companies [Except few exceptions mentioned in question no. 6]
Restriction on Holding company having more than 2 layers of subsidiaries Investing through more than 2 layers of investment subsidiaries
Entity at the end of the loop of the layer Can be a body corporate Has to be a company
Investment through Can be through bodies corporate Has to be necessarily through investment companies
Onus of complying with the section Holding company Holding company
Criteria of establishing relationship Subsidiary can be either by way of control of composition of board of directors or by way of investment in total share capital of company Holding company has to invest through investment subsidiaries. Investment can be in any security.

Table 1: Difference between the sections 2(87) and 186(1) of the CA, 2013

  1. Understanding layers with the help of few illustrations:

Illustration 1:

Figure 3: Illustration 1

The above illustration shows the permitted structure.

Illustration 2:

Figure 4: Illustration 2

In the above illustration, Company B being a WOS will be exempted and hence, the permitted layer will be till Company B2.

However, coming to the other vertical investment – Company A is not the ultimate holding of Company C1. Therefore, For Company A, the permitted layer will be till Company C1 (unless falling under the exemption) and for Company C, the permitted layer will be till Company C3.

Illustration 3:

Figure 5: Illustration 3

In this illustration, C2 is not permitted because C1 is not a subsidiary of an NBFC.

Illustration 4:

Figure 6: Illustration 4

a. Can Subsidiary 4 be shifted from WOS 1 to WOS 2? This will not result in any change in the structure or total number of subsidiaries/ step-down subsidiaries; but simply change the immediate holding entity.

Shifting of subsidiary 4 will be regarded as acquisition within the group. Where the subsidiary is a company incorporated outside India, the restriction of breaching the limit of layer of subsidiary shall not apply.

       b. Will the aforesaid exemption hold good even in case of acquiring a company incorporated outside India having an Indian company as its subsidiary at some level/ layer?

In that case, the company will be making an Indian company its subsidiary pursuant to said acquisition. The intent is to exempt from the requirement of acquiring overseas entity which has subsidiaries as per laws of host country. If the Indian company intended to acquire another Indian company in order to make such Indian company its subsidiary, the same would not have been permitted in view of restriction on layers of subsidiary. What cannot be done directly should not be done indirectly as well. Therefore, the aforesaid exemption shall not hold good.


[1] http://egazette.nic.in/WriteReadData/2017/179104.pdf

[2] http://egazette.nic.in/WriteReadData/2017/179105.pdf

[3] http://www.prsindia.org/administrator/uploads/general/1292845141_JPC_REPORT%20on%20stock%20market%20scam.pdf.pdf

[4] http://www.mca.gov.in/Ministry/pdf/Notice_29062017.pdf

[5] http://ebook.mca.gov.in/Default.aspx?page=rules

Mandatory linking of Aadhaar and PAN under PMLA

By Anita Baid, (finserv@vinodkothari.com)

PML Second Amendment Rules

The Ministry of Finance on 1st June, 2017 vide notification No. G.S.R. 538(E) issued the [1]Prevention of Money-Laundering (Maintenance of Records) Second Amendment Rules, 2017 (hereinafter referred to as “Second Amendment Rules”) mandating all account holders of the reporting entities i.e., banks and financial institutions to link Aadhaar number issued by the Unique Identification Authority of India and Permanent Account Number (PAN) or Form No. 60 as defined in Income-tax Rules, 1962. The timelines for the same were as below- Read more

RBI’s P2P Regulations: A step forward or backward?

The Reserve Bank of India issued a Master Directions – Non Banking Financial Company – Peer to Peer Lending Platform (Reserve Bank) Directions, 2017 (hereinafter referred to as “Directions”) on 4th October, 2017[1], which is an extensive statement outlining in detail the various rules and regulations that all existing and prospective entities carrying on or intending to carry on the business of Peer-to-Peer (P2P) lending (hereby known as NBFC-P2P) will have to comply with. These Directions shall come in force with immediate effect and shall apply to all NBFC-P2Ps, i.e. with effect from the date of issuance of the Master Directions, mentioned above.

1. Registration

1.1. Eligibility criteria

The basic eligibility criteria for carrying on the business of setting up a P2P lending platform are as follows:

  • Only a Non-Banking Financial company shall undertake the business of P2P lending platform.
  • All NBFC-P2Ps that are either commencing or carrying on the business of Peer-to-peer lending platform must obtain a Certificate of Registration (CoR) from the bank.
  • Every existing and prospective NBFC-P2P must make an application for registration to the Department of Non-Banking Regulation, Mumbai of RBI.
  • Any company seeking registration as an NBFC-P2P must have Net Owned Funds of at least Rs. 2 Crores or higher as RBI may specify.
  • The RBI has imposed the condition that the company seeking registration must be incorporated in India and must have a robust IT system in place. The management must act in public interest and the directors and promoters must be fit and proper.

While the eligibility criteria remains same for those already into business and prospective ones, however, there is a slight difference in the way the application process of these two categories will be dealt with by the RBI.

1.2. Prospective P2Ps

An entity intending to set up a P2P lending platform will have to make an application to the RBI and at the time of making the application, it should achieve net-owned funds of Rs. 2 crores which must be parked into Fixed Deposit.

Upon submission of the application, if the RBI is of the view that the aforesaid conditions have been fulfilled, it will grant an in-principle approval for setting up of a P2P lending platform, subject to such conditions which it may consider fit to impose. This approval will be valid for a maximum of 12 months from the date of granting of the approval. Within this period of 12 months, the company must put in place the technology platform, enter into all other legal documentations required. We are of the view that during this period, the entity will be allowed to break the fixed deposit and utilize that money to incur capital expenditure as the ones mentioned above. The entity will have to report position of compliance with the terms of grant of in-principle approval to the RBI.

Once the systems are in place and the RBI is satisfied that the entity is ready to commence operations, it shall grant the Certificate of Registration as an NBFC–P2P.

This high NOF requirements and the long gestation can deter prospective players from entering into the market.

1.3. Existing P2Ps

The situation will be different for entities who are already into the business. Any entity carrying out the business of Peer-to-peer lending platform as on the effective date of these Directions, can continue to do so provided that they apply for registration as an NBFC-P2P to the RBI  within 3 months from the date of effect of these Directions. This will however, not hamper their business, as the RBI allows them to carry on the business, during the pendency of the application and until the application for issuance of CoR is rejected. If the application is rejected, the applicant will have to wind up its business.

2. Scope of Activities

The Master Directions, next, discuss about the Dos and Don’ts of the P2P lending platforms. Let us first discuss about the Dos.

2.1. Dos

An NBFC-P2P can only act as an intermediary that provides an online platform to the participants, i.e., borrowers and lenders, involved in P2P lending. It should ensure adherence to legal requirements applicable to the participants as prescribed under relevant laws, which means this includes the KYC Directions prescribed by RBI.  It is also required to store and process all data relating to its activities and participants on hardware located within India. It is permitted to invest in instruments specified by RBI provided they are not traded in.

Another important function that has been added to the scope of the NBFC-P2P credit assessment and risk profiling of the borrowers, the findings of which must be disclosed to the prospective lenders. Earlier, only few of the platforms carried out underwriting on behalf of the lenders, but, henceforth, this is something that a platform will have to carry out mandatorily.

In addition to the above, NBFC-P2Ps will have to get themselves registered with all the Credit Information Companies (CICs) in the country and file the credit information (relating to borrowers), and update them regularly on a monthly basis or at such shorter intervals as may be mutually agreed upon between the NBFC-P2P and the CICs.

NBFC-P2Ps shall also ensure that appropriate agreements are executed between the participants and the platform, which should categorically specify the terms and conditions agreed between the borrower, lender and the platform. The interest rates to be charged on the loans must be displayed in Annualized Percentage Rate (APR) format on the website of the platform.

2.2. Don’ts

Despite being an NBFC, NBFC-P2Ps are prohibited from lending on its own. It shall ONLY act as an intermediary and nothing more. It should not provide or arrange any credit enhancement or credit guarantee and also all loans intermediated must be purely unsecured in nature. It is required to maintain an escrow account to transfer funds and should not hold on its own balance sheet any funds received from lenders for lending, or from borrowers for repayment. It is prohibited from cross-selling any product on its platform except for loan specific insurance products. International flow of funds is also not permitted for NBFC-P2Ps.

During surveys we have observed that some P2Ps have been engaged in lending through their own platforms. This will have to be stopped now. P2Ps are not allowed to carry on any other activity other than P2P loan intermediation. This is much stricter regulation than for any other type of NBFC.  Mortgage guarantee companies are allowed to take up any other activity up to 10% of its total assets. All other NBFCs must in general satisfy the principality requirements- at least 50% of its total assets must be financial assets and at least 50% of its total income must be from these assets. This is far more lenient than that being allowed for P2Ps.

 

 

3. Prudential Norms

Like all other Directions issued by the RBI for NBFCs, these Directions also lay down the prudential regulations for this class of entities. They are as follows:

  1. Leverage: The outside liabilities of a platform must not exceed 2 times of its owned funds;
  2. Concentration limits: The Directions provide for several concentration limits, which are:
    1. Maximum that a single lender can lend across all P2P platforms – Rs. 10 lakhs;
    2. Maximum that a single borrower can borrow across all P2P platforms – Rs. 10 lakhs;
  • Maximum that a single lender can lend to a single borrower across all P2P platforms – Rs. 50,000;

One apparent concerns that we can point out in this regard is as follows:

Say for instance, a borrower requires a funding of Rs. 5 lakhs, in such case, the platform will have require at least 20 lenders empanelled with itself to meet the requirements of the borrower. Thus, the platforms will have to have large lender base to survive and be able to satisfy loan requirements of borrowers. Therefore, the success of the platforms will be directly related to the scalability of their business.

The P2Ps are also required to obtain a certificate from the borrower and lender, as applicable, that the aforementioned limits are being adhered to.

  1. Tenure: The tenure of the loans extended through the platforms cannot exceed 36 months.

4. Operational Guidelines

An NBFC-P2P is required to have a Board approved policy in place specifying the eligibility criteria, pricing of services and rules for matching participants on its platform.

The Directions explicitly state that the obligation of an NBFC-P2P does not diminish towards those activities that it has outsourced. It will be held responsible for the actions of its service providers including recovery agents and the confidentiality of information pertaining to the participant that is available with the service provider.

5. Transparency

The Directions has provided for one way transparency. On one hand, it states that the NBFC-P2Ps must disclose to the lender details about the borrower including:

  • personal identity;
  • required amount;
  • interest rate sought; and credit score as per the P2P’s credit rating mechanism;
  • terms and conditions of the loan, including
    • likely return; and
    • fees and taxes associated with the loan.

On the other hand it requires the NBFC-P2Ps to make the following disclosures to the borrowers:

  • amount of loan proposed by the lender
  • the interest rate offered by the lender etc.

However, it restricts the platform to give out the personal identity and contact details of the lender to the borrower.

Therefore, the Directions provide for full transparency with respect to borrower’s information but partial transparency with respect to lender’s information.

Apart from information of the participants, the Directions require the platforms to provide the following information on its website:

  1. overview of credit assessment/score methodology and factors considered;
  2. disclosures on usage/protection of data;
  3. grievance redressal mechanism;
  4. portfolio performance including share of non-performing assets on a monthly basis and segregation by age; and
  5. its broad business model.

6. Signing of the loan terms

One of the requirements of the Direction is that no loan shall be disbursed unless the individual lender has approved the individual recipient of loan and all the concerned parties have signed the loan contract.

Here it is important to take a note that while signing the terms of loan, sufficient measures must be taken by the platform to ensure that the personal and contact details of the lender continues are not revealed to the borrower, owing to the restrictions imposed by the Directions on the platform with respect to transparency.

7. Fund Transfer Mechanism

RBI has put a lot of focus on implementing an efficient fund transfer mechanism in order to eliminate any fears of money laundering or usage by the company for its benefit. The Directions stipulate that Fund transfer between the participants on the Peer-to-peer lending platform must take place through escrow accounts which will be operated by a trustee, who must mandatorily be promoted by the bank maintaining the escrow accounts. At least 2 escrows accounts must be maintained – one comprising funds received from lenders and pending disbursal, and the other for collection from borrowers as repayment of loans. All forms of transfer of funds must take place through bank accounts ONLY and cash transactions are prohibited. The graphical representation of the proposed mechanism was included in the Directions, the same has been reproduced below for your reference.

 

The graphic provided on the Directions for the funds transfer mechanism is somewhat ambiguous as it shows only one escrow account, and also shows direct flow of instructions between the lender/borrower and the Trust, which is odd, as it is the platform who should control the flow of information to the Trust.

8. Fair Practices Code

NBFC-P2Ps are required to follow the usual NBFC related Fair Practices Code (FPC) with the approval of its board. They are further required to disclose the same on their website for the information of various stakeholders.

The NBFC-P2Ps are prohibited from providing any assurances on the recovery of loans.
The platform is required to post the following disclaimer on its website –

“Reserve Bank of India does not accept any responsibility for the correctness of any of the statements or representations made or opinions expressed by the NBFC-P2P, and does not provide any assurance for repayment of the loans lent on it”

The Board of Directors shall also provide for periodic review of the compliance of the Fair Practices Code and the functioning of the grievances redressal mechanism at various levels of management. A consolidated report of such reviews shall be submitted to the Board at regular intervals, as may be prescribed by it.

9.Information Technology Framework

Given the fact that the core operation of P2P lending platforms depends on a robust IT framework, the Directions state that the technology must be scalable in nature to handle growth in business. The Directions also stipulate that there should be adequate safeguards built in its IT systems to ensure that it is protected against unauthorized access, alteration, destruction, disclosure or dissemination of records and data. The RBI also reserves the right to, from time to time, prescribe technical specifications, as deemed fit. The rest of the IT laws are same as those issued to NBFC-SIs in general.

10.Fit and Proper Criteria

An NBFC-P2P must ensure that a policy is put in place with the approval of Board of Directors, setting out the ‘Fit and Proper’ criteria to be met by its directors and also obtain a Deed of Covenants signed by the Directors. RBI may, if it deems fit and in public interest, may independently assess the directors and have the power to remove the concerned directors.

The guidelines have, surprisingly, been kept at par with NBFC-SI. The Deed of Covenants, regular reporting requirements etc. are all observed by NBFCs which are systemically important i.e. NBFCs having asset size of over 500 crores. For P2P platforms to have to observe these is perhaps over-regulation.

11.Requirement to obtain prior approval of the Bank for allotment of shares, acquisition or transfer of control of NBFC-P2P

Given the fact that most P2P lending platforms are start-ups in nature, the requirements are very restrictive in nature. The Directions stipulate that prior approval from the banks will be required in case of:

  1. any allotment of shares which will take the aggregate holding of an individual or group to equivalent of 26 per cent and more of the paid up capital of the NBFC-P2P;
  2. any takeover or acquisition of control of an NBFC-P2P, which may or may not result in change of management;
  3. any change in the shareholding of an NBFC-P2P, including progressive increases over time, which would result in acquisition by/ transfer of shareholding to, any entity, of 26 per cent or more of the paid up equity capital of the NBFC-P2P;
  4. any change in the management of the NBFC-P2P which would result in change in more than 30 per cent of the Directors, excluding independent Directors;
  5. any change in shareholding that will give the acquirer a right to nominate a Director

A public notice of at least 30 days shall be given before effecting the sale or transfer of the ownership.

The format for application for prior approval is the same as for other NBFCs.

This is quite unprecedented level of regulation and will seriously increase the bureaucracy PE/VC investors and startups have to go through before a funding round can be closed.  Even a 1% allotment which takes one’s shareholding past 26%, then prior permission will be required. Again, should an investor want the right to nominate a Director, then prior approval will be required. This level of regulation is higher than for regular NBFCs and would slow down the process of investments in P2P platforms in India.

12. Reporting Requirements

NBFC-P2Ps must submit a statement showing number and amount of loans during, at the closing of and outstanding at the beginning and end of quarter, including the number of lenders and borrowers outstanding as at the end of quarter to RBI regional office within 15 days after the quarter to which they relate.

They must also disclose the amount of funds held in the Escrow Account, with credit and debit summations for the quarter. Further, number of complaints outstanding at the beginning and end of quarter and disposed of during the quarter, bifurcated between the lenders and borrowers must also be disclosed in order to constantly improve the state of the industry.

13. Conclusion

The regulations on P2P platform was much awaited, but the way the Directions have been crafted, this could cause serious damage to these platforms. To start with, the requirement of maintaining NOF of Rs. 2 crores is not justified since the business is not a capital intensive one. Next, we also feel that RBI has taken a very cautious approach with respect to the credit concentration, however, we feel that this may be enhanced in the future looking at the performance of the sector. Next, the time required for registration of new P2P platforms also seems to be on the higher side. Further, the list of instances for which prior approval will have to be sought from RBI by the platform, may act as a deterrent for the investors who may interested in investing in P2P platforms.

Having said that, the attempt of giving a regulatory shape to the P2P businesses in India, itself must be applauded.


[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11137

The Financial Resolution and Deposit Insurance Bill, 2017: Key Highlights

By Nidhi Bothra, (nidhi@vinodkothari.com)

 

In March, 2016 a committee was constituted under the Chairmanship of Mr. Ajay Tyagi to draft and submit a bill on resolution of financial firms. In September, 2016, the Committee submitted its report and bill which was titled as “The Financial Resolution and Deposit Insurance Bill, 2016”[1] (Bill 2016). The objective of the Bill, 2016 was to provide for a framework for safeguarding the stability and viability of financial services providers and to protect the interest of the depositors, as the name of the bill also suggests[2].

The Financial Resolution and Deposit Insurance Bill, 2017[3] (Bill, 2017) is formulated to provide resolution to certain categories of financial service providers in distress; the deposit insurance to consumers of certain categories of financial services; designation of systemically important financial institutions; and establishment of a Resolution Corporation for protection of consumers of specified service providers and of public funds for ensuring the stability and resilience of the financial system and for matters connected therewith or incidental thereto.

The proposed legislation together with the Insolvency and Bankruptcy Code, 2016 is expected to provide a comprehensive resolution mechanism for the economy.

The existing draft of the Bill, 2017 has been referred to a Joint Parliamentary Committee of both the Houses, under the Chairpersonship of Shri Bhupender Yadav, for examination and presenting a Report to the Parliament.

The Bill is divided into several chapters, which deal with establishment of a Resolution Corporation, its powers, management and functioning which is broadly to function along with the appropriate regulator[4] of financial services provider, classification of persons as systematically important financial institutions, deposit insurance, restoration and resolution plan, method of resolution, liquidation etc.

Highlights of the Bill, 2017

The brief highlights of the Bill[5], 2017 are as follows:

  1. Establishing the Resolution Corporation – A resolution corporation would be formulated broadly with the objective of
    1. monitoring certain financial services provider[6];
    2. providing deposit insurance to banking institutions;
    3. classifying certain persons as specified service provider [7] into one of the categories of risks to viability;
    4. acting as an administrator or liquidator for such service provider or resolve a specified service provider which has been classified into critical risk category;
    5. set up funds including Corporation Insurance Fund, set up for deposit insurance provided by the Corporation to the insured service providers[8] and other funds such as Corporation Resolution Fund for meeting the expenses of carrying out resolution of specified service providers and Corporation General Fund for all other functions of the Corporation.
  2. Deposit Insurance – Chapter IV of the Bill, 2017 discusses about deposit insurance and largely deals with
    1. Determination of amount payable by the Corporation, to a depositor on account of deposit insured;
    2. Amount payable to an insured service provider[9] on account of resolution but not bail-out or eligible co-operative bank on account of merger or amalgamation;
    3. If the Resolution Corporation is dealing with the resolution of an insured service provider, then the Corporation may decide to invite offers from other insured service providers to take over the liabilities, deposits or realisable assets of the insured service provider.
  3. Categorisation as SIFIs[10] – Certain persons can be classified as SIFIs by the Central Government in consultation with the appropriate regulator, as per Section 25 of the Bill, 2017, if it meets the criteria prescribed by the Central Government in this regard. Once categorised as an SIFI, then are deemed to be specified service provider and the provisions of being a specified service provider under the Bill, 2017 become applicable to them. It is important to mention that any financial service provider or domestic systematically important banks can be classified as SIFIs. Once classified as SIFIs, the Central Government may designate, its holding, subsidiary, associate company or any other body corporate related to it as financial service provider and falling into the ambit of being SIFI.
  4. Registration of specified service provider – Chapter V of the Bill, 2017 talks about registration of specified service providers and states that if a person classified as a specified service provider or deemed to be a service provider, it shall be deemed to be registered under the Act, from the date of classification. If the appropriate regulator has issued a license in favour of a specified service provider, such license shall be deemed to be registration for the purpose of this Act as well.
  5. Risk to viability categories – The Bill, 2017 specifies 5 categories[11] of risk to viability under Section 36 (5) and are as follows —
    1. low, where the probability of failure of a specified service provider is substantially below the acceptable probability of failure;
    2. moderate, where the probability of failure of a specified service provider is marginally below or equal to acceptable probability of failure;
    3. material, where the probability of failure of a specified service provider is marginally above acceptable probability of failure;
    4. imminent, where the probability of failure of a specified service provider is substantially above the acceptable probability of failure;
    5. critical, where the probability of failure of a specified service provider is substantially above the acceptable probability of failure, and the specified service provider is on the verge of failing to meet its obligations to its consumers

The classification of a specified service provider into any of the categories of risk to viability except the category of critical risk to viability under section 45, shall be kept confidential by the appropriate regulator, the Corporation and by all relevant parties.

6.   Categorisation of specified service providers under risk to viability categories

  1. The Resolution Corporation in consultation with the appropriate regulator categorise specified service providers under risk to viability categories.
  2. The Resolution Corporation shall have no power to classify a specified service provider into the category of low or moderate risk to viability.
  3. While classifying under risk categories, they can assess, evaluate and classify the holding or non-regulated operational entity within the group of the specified service provider as deemed to be a specified service provider.

7.   Restoration and Resolution Plan — Any specified service provider, classified in the category of material or imminent risk to viability shall submit a restoration plan to the appropriate regulator and a resolution plan to the Corporation within ninety days of such classification. Every restoration plan will prescribe for the details of restoring category to low moderate and resolution plan on who resolution will be achieved.

Where a systemically important financial institution is classified in the category of low or moderate risk to viability, it shall submit the information required under this subsection assuming that it is classified in the category of material or imminent risk to viability.

Where the Resolution Corporation determines that liquidation is the most appropriate method for the resolution of a specified service provider, notwithstanding anything in any other law for the time being in force relating to liquidation and winding up, the Corporation shall make an application to the Tribunal for an order of liquidation in respect of such specified service provider.

The detailed actions as prescribed under the Bill for various categories of risks is tabulated in Annexure I to this note.

Changes from the Bill, 2016

The Bill, 2016 aimed at including all NBFCs its foray. Bill, 2017 only intends to cover such NBFCs and other entities in the group, if such NBFC is classified on high risks to viability categories. This was an important and a necessary change from the Bill, 2016.

All the NBFCs, big and small will be continued to be monitored by the appropriate regulators, however, matters will get escalated only if they are on the risks to viability meter. Similar would be the case with other financial services providers as well.

Some key issues

Some key issues that the Bill, 2017 does not address or overlook are as follows:

  1. Definition of financial services provider – The Bill does not provide for a definition of financial services providers. The specified services provider will be deduced from the financial services providers, by and large. However the Bill, 2017 does not expressly provide for the universe of which the monitoring will be carried out. The Bill, 2017 indicates, NBFCs, insurance companies and banking institutions will fall in the ambit of discussion.
  2. NBFC-Ds – While the concept continues to be theoretical for all practical purposes, but the Bill, 2017 does not make a mention at all of this category of entities.
  3. Resolution and restoration plan — Chapter VII provides for resolution plan and restoration plan to be submitted to appropriate regulator and resolution corporation for material and imminent risk category specified service providers. The plans are to be submitted with 90 days. The brief contents of the plans to be provided to the authorities is prescribed in the Bill, 2017. However, are both plans to be provided within 90 days from the date of categorisation and for both categories?

For both categories of risks to viability, there can be strong intervention of the authorities in running of the business itself. One may find it difficult to find the distinction between the two categories of the risks to viability as the action taken by the authorities and from the specified service providers seems to be almost similar.

In case an entity is categorised as critical risk to viability, the turnaround of the resolution plan is to be carried out within one year, else the Resolution Corporation may require the liquidation of the entity. The entities, in determination here have an element of systemic risks and therefore liquidation of such entities can have daunting consequences on the economy. The provision for triggering liquidation should be well defined or determined in consultation with the Central Government.

4.   Rule-making – The devil, as they say, lies in the details. A lot of actions to be taken in each of the risks categorisation will come by way of rule-making. This will determine the effectiveness of the resolution plans and restoration plans prescribed in the Bill, 2017.

5.  Existing resolution mechanisms – The appropriate regulators have introduced several policy initiatives and resolution guidance and schemes for restructuring of stressed assets, special restructuring norms, strategic restructuring norms, corporate debt restructuring wherein the entities were required to submit resolution/ restructuring/ restoration plans within certain timeframes. The experience with these guidelines have indicated the failure of these guidelines and schemes to provide for a resolution plan within the dedicated time frame and also restoring the position of the entities.Therefore, appropriate learnings from those guidelines should also be reflected in the Bill,2017.

Annexure I

SL no. Category of risk to viability (Section 36) Categorised by ** Immediate action to be taken by the specified service provider Continued Action required by the specified service provider Action taken by appropriate regulator and/ or corporation
 
1 Low Appropriate Regulator No Action taken, regular monitoring of the activities of the entity may be conducted.

Where a SIFI is classified in the category of low or moderate risk to viability, it shall submit the information required under section 39 (2) assuming that it is classified in the category of material or imminent risk to viability.

2 Moderate Appropriate Regulator No Action taken, regular monitoring of the activities of the entity may be conducted.

Where a SIFI is classified in the category of low or moderate risk to viability, it shall submit the information required under section 39 (2) assuming that it is classified in the category of material or imminent risk to viability.

3 Material Resolution Corporation or Appropriate Regulator Submit a restoration plan[12] to the appropriate regulator and a resolution plan[13] to the resolution corporation within 90 days of such classification.

A copy of the restoration plan and resolution plan to be submitted to the resolution corporation and appropriate regulator respectively, within 15 days of the first submission, thereof.

Every systemically important financial institution shall submit a restoration plan to the appropriate regulator and a resolution plan to the Corporation within ninety days of its designation under section 25.

Every restoration plan or resolution plan shall be revised annually and the appropriate regulator and the Corporation shall be informed of such revised restoration plan, within seven days of the revision.

Every material change shall be immediately informed to the appropriate regulator and the Corporation.

Additional inspection may be carried out to monitor the risk to viability.

Appropriate regulator may prevent entity from taking certain business decisions including declaration of dividend, establishing new business or acquiring new clients, undertaking related party transactions, increasing liabilities etc.

Appropriate regulator may require the entity to increase capital, sell assets etc.

4 Imminent Resolution Corporation or Appropriate Regulator

 

Or

If the specified service provider has not submitted the restoration plan or resolution plan within prescribed time frame.

Submit a restoration plan to the appropriate regulator and a resolution plan to the resolution corporation within 90 days of such classification.

A copy of the restoration plan and resolution plan to be submitted to the resolution corporation and appropriate regulator respectively, within 15 days of the first submission, thereof.

Every systemically important financial institution shall submit a restoration plan to the appropriate regulator and a resolution plan to the Corporation within ninety days of its designation under section 25.

Every restoration plan or resolution plan shall be revised annually and the appropriate regulator and the Corporation shall be informed of such revised restoration plan, within seven days of the revision.

Every material change shall be immediately informed to the appropriate regulator and the Corporation.

The resolution corporation may appoint an officer to inspect the functioning of the entity and act as an observer.

The corporation may prevent the entity from accepting funds, declaring dividend, acquiring new businesses or new clients, undertake related party transactions etc.

The corporation may require the entity to infuse new capital or sell identified assets etc.

 

A specified service provider classified in the category of imminent risk to viability shall, if it is not a SIFI, submit a resolution plan to the Corporation within 90 days.

 

5 Critical Resolution Corporation or Appropriate Regulator – effective from the date of publication in official gazette N.A. N.A. Corporation shall be deemed to be the administrator[14] and may take the following actions:

a.       resolve the issue through a scheme or merger or amalgamation or bail-in instrument.

b.      Transfer whole or part of assets/ liabilities to another person

c.       Create a bridge service provider

d.      Cause liquidation of the entity

e.       No legal action or proceeding including arbitration shall commence or continue until conclusion of resolution.

f.       No repayment or acceptance of deposit shall be made or liabilities incurred.

g.      temporarily prohibit (not exceeding 2 business days) by an order in writing, the exercise of such termination rights of any party to such specified contract with the relevant specified service provider or its associate company or subsidiary

License granted to the entity by the appropriate regulator may be withdrawn or modified.

 


[1] http://dea.gov.in/sites/default/files/FRDI%20Bill-27092016_1.pdf

[2] See our article titled – Financial Resolution and Deposit Insurance Bill: Implications for NBFCs, by Vinod Kothari and Niddhi Parmar, here http://vinodkothari.com/blog/financial-resolution-and-deposit-insurance-bill-implications-for-nbfcs-by-niddhi-parmar/

[3] http://164.100.47.4/BillsTexts/LSBillTexts/Asintroduced/165_2017_LS_Eng.pdf

[4] Appropriate Regulator is defined in First Schedule to the Bill, 2017 to include a) RBI, b) IRDA, c) SEBI, d) Pension Fund Regulatory Development Authority or any other regulator as notified by the Central Government.

[5] http://164.100.47.4/BillsTexts/LSBillTexts/Asintroduced/165_2017_LS_Eng.pdf

[6] Financial services provider categorised as specified service providers and SIFIs fall within the purview of the Resolution Corporation. The detailed mechanism of monitoring is discussed further in the highlights.

[7] A specified service provider is a person as defined in Second Schedule to Bill, 2017 and includes

  1. A banking institution, , other than eligible co-operative bank including an insured service provider;
  2. Any insurance company
  3. Any Financial Market Infrastructure
  4. Any payment system, as defined under the Payment and Settlement Systems Act, 2007 (51 of 2007), not notified under section 227 of the Insolvency and Bankruptcy Code, 2016 (31 of 2016)
  5. Any non-banking financial company, not notified under section 227 of the Insolvency and Bankruptcy Code, 2016 (31 of 2016)
  6. Any systemically important financial institution
  7. Any other financial service provider (excluding individuals and partnership firms), not notified under section 227 of the Insolvency and Bankruptcy Code, 2016 (31 of 2016)
  8. A holding company of any specified service provider enumerated under items 1 to 7, registered in India which is not notified under section 227 of the Insolvency and Bankruptcy Code, 2016 (31 of 2016), subject to the determination by the Corporation under the proviso to sub-section (1) of section 33
  9. Non-regulated operational entities within a financial group or conglomerate of a specified service provider enumerated under items 1 to 7 subject to the determination by the Corporation under the proviso to sub-section (1) of section 33.
  10. Branch offices of body corporates incorporated outside India, carrying on the business of providing financial service in India.
  11. Any other entity or fund which may be notified by the Central Government

[8] As defined in Section 2 (19) of the Bill, 2017 — means any banking institution, that has obtained deposit insurance under sub-section (3) of section 33. Section 33 (3) states that every banking institution that has been granted a banking license by the appropriate regulator shall be deemed to be categorised as insured service provider for obtaining deposit insurance under the Act.

[9] Insured service provider is a banking institution that has obtained deposit insurance

[10] To qualify as an SIFI, the Central Government will consider the size, complexity of the financial service provider, the nature and volume of transactions undertaken, interconnectedness with other financial service providers and nature of services offered and possibility of substitution such business.

[11] The categorisation are based on assessment of the following parameters:

(a) adequacy of capital, assets and liability; (b) asset quality; (c) capability of management; (d) earnings sufficiency; (e) leverage ratio; (f) liquidity of the specified service provider; (g) sensitivity of the specified service provider to adverse market conditions; (h) compliance with applicable laws; (i) risk of failure of a holding company of a specified service provider or a connected body corporate in India or abroad; and (j) any other attributes as the Corporation deems necessary

[12] A restoration plan as per the provisions of Section 39, will contain details of assets and liabilities of the entity, including contingent liabilities, steps to be taken by the entity to move to moderate classification at least, time frame within which such restoration plan will be executed and other information relevant for the appropriate regulator to assess the plan.

[13] A resolution plan, as per the provisions of Section 40, will contain details of assets and liabilities of the entity, identification of critical functions of the specified service provider, access to financial market infrastructure services, either directly or indirectly, strategy plans on exiting the resolution process and any other relevant information.

[14] The resolution plan must be completed within one year from the date of classification into critical risk to viability. Where the plan is completed within one year and the Corporation deems necessary, it shall require liquidation of the entity.